Question

Suppose the quality of Hong Kong products relative to foreign products deteriorates.
a. Explain how the quality deterioration of Hong Kong products affects Hong Kong’s exports at any given exchange rate.
b. Explain how the quality deterioration of Hong Kong products affects Hong Kong’s real exchange rate and trade balance.
c. Is it possible that the quality deterioration of Hong Kong products increases Hong Kong’s trade deficit?

Answer 1

A) Product quality deterioration will lead to fall in demand for the good in the world market, leading to fall in demand for its exports.

B) Since trade balance = exports - imports, a fall in exports will lead to a fall in HK trade balance

Due to fall in exports, demand for HK currency will also fall. This will lead to leftward shift of demand curve of HK currency, leading to currency depreciation

C) Trade deficit will rise, as exports will fall. This will reduce export income and hence increase trade deficit